Academic journal article Brookings Papers on Economic Activity

Is a Household Debt Overhang Holding Back Consumption?

Academic journal article Brookings Papers on Economic Activity

Is a Household Debt Overhang Holding Back Consumption?

Article excerpt

ABSTRACT The recent plunge in U.S. home prices left many households that had borrowed voraciously during the credit boom highly leveraged, with very high levels of debt relative to the value of their assets. Analysts often assert that this "debt overhang" created a need for household deleveraging that, in turn, has been depressing consumer spending and impeding the economic recovery. This paper uses household-level data to examine this hypothesis. I find that highly leveraged homeowners had larger declines in spending between 2007 and 2009 than other homeowners, despite having smaller changes in net worth, suggesting that their leverage weighed on consumption above and beyond what would have been predicted by wealth effects alone. Results from regressions that control for wealth effects and other factors support the view that excessive leverage has contributed to the weakness in consumption. I also show that U.S. households, on the whole, have made limited progress in reducing leverage over the past few years. It may take many years for some households to reduce their leverage to precrisis norms. Thus, the effects of deleveraging may persist for some time to come.

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The bursting of the U.S. housing bubble inflicted enormous damage on household finances. Besides contributing to a significant decline in the net worth of homeowners, the plunge in home prices left many of those who had borrowed voraciously during the credit boom highly leveraged, meaning that they had very high levels of debt relative to the value of their assets. Analysts often assert that this "debt overhang" created a need for household deleveraging that, in turn, has been depressing consumer spending and impeding the economic recovery.

The past few years have indeed seen both a sizable decline in aggregate household debt and weak growth in aggregate consumer spending. However, the nature of the relationship between these two developments is not well understood. According to the simplest models used by economists, a household's consumption is determined by its income (actual and expected), wealth, preferences, and the return it earns on savings. In slightly more refined models, the uncertainty faced by a household plays a role, as does its ability to borrow. However, debt does not typically exert an independent influence on consumption in traditional models; rather, borrowing is presumed to vary with consumption, as the latter rises and falls in reaction to changes in its determinants.

The traditional framework points to many factors that may be contributing to the lackluster performance of consumer spending in recent years. Wealth losses, weak income growth, and limited availability of credit, as well as a more uncertain and pessimistic outlook for future income, would all be expected to have depressed spending. Within the traditional framework, the observed decline in debt over the past few years would be interpreted as the result of weak consumption growth rather than a driving force in and of itself.

This paper asks whether a need to reverse the run-up in leverage that arose from the credit boom and subsequent collapse in home prices is in fact contributing to the recent weakness in consumer spending. To test this deleveraging hypothesis, I look at whether the households with the greatest mortgage leverage several years ago have reduced their spending the most, all else equal. I use household-level data so that I can control for other factors that might have led highly leveraged households to have different patterns of consumption than their counterparts with less leverage.

High levels of debt and leverage might have had an independent influence on consumer spending for several reasons. First, some households may target a given level of leverage; the sharp rise in leverage that occurred with the slump in home prices may have induced these households to pare back their consumption in order to pay down debt. …

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